The Last Bright Spot

Can corporate profits continue to rise?

This year, the otherwise dismal economy has had two real bright spots: a rally in the stock market and rising corporate profits. One of those things is now gone. The question of what will happen with the other remains.

In the last two weeks, the Dow Jones has given up all the gains it had accrued since Jan. 1—and then some, wiping out trillions in equity value. That leaves just one real bright light in the economy: corporate profits. Indeed, during 2010 and 2011, America's companies have made out like bandits. In the first three months of this year—the last quarter for which we have official statistics—profits from current production increased by nearly $50 billion. Both nonfinancial and financial firms have expanded their earnings year-on-year. The bounce-back for corporations has proved so robust that their profits accounted for the highest proportion of national income ever recorded in 2010.

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The Bureau of Economic Analysis explains how companies have done so well when the economy has done so poorly in its most recent release on the subject: "The increase in unit profits reflected an increase in unit prices and a decrease in the unit labor costs." In other words, after the recession, businesses shed workers, boosted productivity, and expanded overseas, doing more with less to remain profitable despite dampened domestic sales. Corporations have continued to pay workers less to retain their margins through 2011.

Despite the recent slowdown stateside, signs are that businesses are still running record-high profits. According to an analysis by Bloomberg, three out of four companies listed on the S&P 500 exceeded their earnings estimates in the second quarter. Stock analysts believe that profits at companies on the index will rise 18 percent this year and 14 percent next year, slow growth be damned. And all those earnings continue to show up in the corporate cash hoard. Corporations have boosted their cash holdings for 10 straight quarters and are sitting on more than $1 trillion.

So might companies' good fortunes turn into workers' good fortunes, helping to jumpstart the broader recovery? Corporations could take advantage of the record-low interest rates and cheap idle labor to invest and expand domestically, helping bring down the unemployment rate and kick off stronger growth. Thus far, they haven't, given the sluggish pace of growth and the slow process of deleveraging. (See the Catch-22 there?) They have instead hoarded their money, increased dividends, acquired other businesses, and soaked up their own shares—helping their bottom lines and their investors but not America's jobless workers.

Businesses are hunkering down—and with good reason. There are signs that corporate profits could start to thin. Consider the concise, brutal summary of current economic conditions in the Federal Open Market Committee notes released today. "[E]conomic growth so far this year has been considerably slower than the Committee had expected. Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed."

Companies have to contend with the possible double-dip and the cuts to consumer spending and business investment that might come with it. They also need to combat rising fuel and commodity costs, which slimmed some companies' profits in the first half of the year. Moreover, big corporations need to deal with the scary situation in Europe and a possible slowdown in Asia.

For right now, America's companies seem to be weathering the storm well—holding onto cash in case there is another downturn and keeping their margins thick. Analysts expect them to continue to do well for the remainder of this year and next. But the likelihood that corporate profits will start to get hit by the overall malaise, rather than helping to end it, seems likely—and probably helps to account for the selloff in stocks over the last two weeks.